* Italian auction sees strong demand as yields rise
* Post-election uncertainty seen keeping pressure on Italy
* German debt gains as markets remain risk averse
By Marius Zaharia
LONDON, Feb 27 Lower-rated euro zone bonds
stabilised on Wednesday after an Italian debt auction drew ample
demand, albeit at sharply higher yields, after an electoral
stalemate there prompted a sell-off early in the week.
The relief may be short-lived, however, as investors
continue to fret about Italy's ability to reform its indebted
economy following the weekend poll, which showcased the lack of
popular support for austerity and resulted in a hung parliament.
Italian 10-year yields had shot 50 basis
points higher as the election results emerged, taking them to
around 4.90 percent - enough to persuade some, mainly domestic,
investors to snap up the cheapened paper at auction.
Italy sold a maximum planned amount of 6.5 billion euros in
five- and 10-year bonds, with demand higher than at a previous
tender. Its 10-year cost of funds was the most since October,
however, at 4.83 percent.
"The auction went relatively well so probably the fact that
yields approached 5 percent triggered some demand," BNP Paribas
rate strategist Patrick Jacq said.
"Italy remains quite fragile, the bid for safety remains
intact, but ... (the yield) is relatively attractive."
Highlighting the ongoing worries about the uncertain
political outlook, a post-auction dip in Italian 10-year yields
to 4.82 percent reversed within minutes. Similarly, safe haven
Bund futures bounced off session lows of 144.81 to last
trade 33 ticks higher on the day at 145.23.
Traders said demand at the Italian debt sale was likely to
have been supported mainly by domestic accounts, while foreign
funds used the brief post-auction market cheer to sell more
peripheral debt and buy low-risk instruments.
"We rule out (that) foreign accounts have played a major
role at today's auction as political risks remain high," said
Annalisa Piazza, market economist at Newedge.
Investec fixed income analyst Elisabeth Afseth expected
10-year Italian yields to rise above 5 percent and stay there
unless political parties "surprise us and come up with a
workable parliamentary solution."
"I'd be happier to sit with core bonds with low yields for
the next month or two," she said.
If prolonged, the political deadlock could create a new wave
of contagion in the euro zone, seven months after European
Central Bank President Mario Draghi won some respite with his
pledge to do "whatever it takes" to save the euro.
The ECB's bond-buying programme (OMT) is still seen as a
force acting against debt costs reaching unsustainable levels.
But it requires countries to first apply for aid and then stick
to an agreed programme of austerity, raising questions about how
soon it could be activated.
"Italy has reminded everyone that triggering the OMT ... is
not as easy as the market thought," said Gilles Moec, economist
at Deutsche Bank. "As it is a reminder of the fragility of the
entire system, it has a negative impact for the risk premium for
the entire periphery."
"Now, is it enough to send us into the kind of mayhem in
which we were last summer? No. It raises the bar for ECB
intervention but it doesn't kill the idea."
Italian 10-year yields are still well below last July's
highs of about 6.7 percent. Spanish, Portuguese and Irish
yields, which have been dragged up by Italy this week, were also
stable on Wednesday, far below last year's highs.
While peripheral markets were expected to remain under
pressure, panic selling was unlikely, analysts said.
"It has some impact on other peripheral debt, but clearly
the world has changed since the ECB decided on the OMT," said
BNP Paribas' Jacq, who was less concerned about the
anti-austerity vote in Italy.
"Do you know one country where people are voting for